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7/23/2008
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The price to earnings ratio is the SP500 divided by the earnings of the companies contained in this key index. While often considered a measure of valuation, one can also look at the PE Ratio as a measure of investor enthusiasm or sentiment. After all, if an investor is willing to pay 30 times earnings for stock or twice the historical norm, then they must be pretty enthusiastic about the future of stock prices. The “P” as in “Price” must grow very significantly. I follow a 13 week smoothed value of the PE Ratio. Looking back 50 years, the mean value of the 13 week moving average of the PE Ratio is 17; 1 standard deviation up is 23.9 and two standard deviations is 30.7. It is difficult to design an indicator let alone a trading system utilizing the PE Ratio. The common wisdom is that high PE Ratios lead to poor returns. While this may be true, there really isn’t enough data to test this assumption. Valuations were high (greater than 23.9 or the 1 standard deviation band) in 1992 and they have remain above this level for the most part since 1998. The March, 2003 low came with the PE Ratio around 30.
Furthermore, a lower PE Ratio always isn’t better. I can design a trading system that takes positions only is the PE Ratio is a certain level and I will utilize the Price Structure Analysis Indicator for entries and exits. The first system is to take all entries when the 13 week moving average of the PE Ratio is below 17 or its 50 year mean. The second system takes all entries when the 13 week moving average of the PE Ratio is between 17 and 24. The results are presented in Table 1. There are some trading parameters that are better when the PE Ratio is less than 17 (i.e., Rina Index) and some that are better when the PE Ratio is less than 24 but greater than 17 (i.e., percent winners, fewer trades, better annual rate of return). When the PE Ratio is less than 17 the equity curve for this system is better looking reflecting smoother and more stable growth of one’s equity. The bottom line: while the PE Ratio is important to watch, it does not make a good trading indicator. It is difficult to say what PE Ratio is the best. Its best use may be as a gauge of investor sentiment. Bond Yield/ Stock Earnings Yield Ratio One valuation measure that is critical to understand is the ratio or value of bond yields to S&P500 earning yields. If bond yields are relatively high compared to stock earning yields, then bonds appear more attractive as this income is guaranteed. Conversely, relatively low ratios favor owing stocks. The indicator I use is a composite indicator that not only measures the rate of change of the ratio between bond yields and stock earnings yields but also it measures the absolute value of this key ratio. This indicator has bullish, neutral and bearish modes and the results of a trading system designed to buy the market when the indicator was in each of its three modes are presented in Table 2. Table 2.
As you can see from the table above, it is critical to monitor the value of S&P500 earnings yields relative to bond yields. However, even the bullish scenario is not without problems unless you would enjoy 30% plus draw downs to your trading capital. By adding a mechanism to improve the efficiency of entries and exits, the Bond Yield to Stock Yield plus Price Structure Analysis trading system has been created. This a long only system. System #1 takes entries only when the indicator is in the bullish scenario; system #2 only takes entries when the indicator is in neutral mode. The results of such a trading system are shown in Table 3. Table 3.
By combing a favorable market climate with an efficient entry and exit strategy, improves the results of either system alone. |
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